Defense Contractors Go on the M&A Offensive

BAE Systems dominates the British defense industry, but there is still room for service and support companies to get business.

Two of these are VT Group and Babcock International. VT Group did about$1.7 billion in turnover in 2009 and Babcock for the year ending in March 2009 $2.8 billion. Both companies focus on providing training and engineering support to the British military. They also do significant commercial work in training, education, infrastructure and energy. VT Group has been able to acquire some U.S. companies; Babcock has focused on providing support to Canada's Navy and has also delivered some submarine parts to the U.S.

There is considerable overlap between the two companies, so it is not surprising that Babcock wants to buy VT Group, an idea the latter has spurned. VT believes it has much more growth potential and doesn't need Babcock. VT Group is currently pursuing its own acquisition of the consulting company Mouchel Group PLC in a deal worth about $500 million.

But Babcock has not given up. It sees buying VT as a way to gain more access to the U.S. market, and as a hedge against being too reliant on the British market.

A similar situation may be facing U.S. contractors. When the U.S. defense budget was falling in the 1990s, this kind of merger was common. Companies large and small joined to broaden their customer and contract base. Two good examples were the mergers of Boeing (BA) and McDonnell Douglas (MD) and Lockheed (LMT) and Martin Marietta. These companies were once direct competitors, but merged when there were not enough contracts to support both. (Boeing and MD were the major civil and military aircraft producers while Lockheed and Martin Marietta were the primary satellite providers.

The Babcock and VT Group fight may signal a similar round of M&A in the U.S. So far, the M&A activity we've seen has been the larger contractors acquiring small to mid-size contractors; the next step will be for the larger companies to join together.

Like the UK, the U.S. could be facing a thinner competitive and industrial base in the next few years.